Saturday, April 23, 2005

Economic Research and Data | FRB Cleveland

Some bloggers seem to be overly anxious about the slowing growth rate of our economy (ironically on the same week that unemployment claims hit a new low). I did a Google search to pull up the above article from the Cleveland Fed, written in 1996. Before discussing the article let me point out that it is natural if not automatic for the growth rate to slow after the first couple of years of recovery.

Lets say that during the recession you are afraid you will lose your job and that your family goes out to eat once per month. When the recovery comes, you have spent a year or more of tight budgets, you have paid off debt and you find yourself in good financial shape. Maybe you start going out to eat four times each month. Others in your community do the same. A year later, you and the economy are doing very well and you may go out five times each month. The restaurants experienced a high revenue growth percentage the first year and a smaller revenue growth percentage the second year. However, the restaurants can now raise prices because they are playing to a full house. All the bloggers start talking about inflation as there is moderate inflation in a healthy economy. Profit margins go up and total profits go up even more because there was growth in revenues and growth in margins.

Finally, the recovery morphs into an expansion. The restaurants are doing so well that they build at new locations. The expansion typically last several years but it is not always the best of times for every business. Sooner or later, one too many restaurants are built. The existing restaurants are no longer playing to a full house. To maintain margins, costs must be cut. If there has been over-expansion in enough businesses, there may be a recession as a cut back in employment at one business leads to lower sales at the next and so on. Sooner or later, the government must "prime the pump" through deficit spending to restart the cycle. Investors need to learn that the best time to invest is when the government is running a deficit and it is a risky time if the government is taking in more revenues than it spends.

One can understand much about where an economy is by studying the yield curve. The above article shows how the curve predicts economic growth reasonably well. In today's economy, it is natural and good that short rates are going up a little. This shows that the economy is strong enough for businesses to desire to borrow money. Market prices are largely determined by the "invisible hand of Adam Smith"; i.e. the market for everything tends to automatically correct itself. Therefore, when short rates go up, it says that there is demand for businesses to borrow but it also says that businesses that have already borrowed are feeling a credit crunch (most business loans are floating rate loans). As the interest costs go up, businesses will be more cautious about expanding and the rate of growth of the entire economy will slow; the GNP growth rate is low when the yield curve is relatively flat. Again, the main reason it is slow is because the year over year comparisons get to be tough after growth has recovered from the recession lows.

The good news for stock investors is that companies are already making big money and are cheaply valued. Business spending continues to be very strong without pushing up rates quickly because businesses are enjoying historically strong cash flow. The current situation is similar to what happened in 1994. The GNP growth rate slowed to a more sustainable level, companies continued to enjoy strong productivity gains, profits continued to increase and stocks did very well for the next five years.

Be a bull with me are be a bear with others but please don't be a whiner.